Mutual Fund Returns Explained: CAGR, XIRR and absolute returns; why all factors matter to investors

Mutual Fund Returns Explained: It’s not just about finding the highest percentage when it comes to understanding returns on mutual funds. Various measures such as CAGR, XIRR, and absolute return are used to calculate performance based on the time and manner of investment. It is essential to understand the meaning of these terms to make informed decisions. Let’s decode it today.

When a fund says it has achieved an average return of 15 per cent over five years, investors need to first understand what this 15 per cent actually means. Concepts like CAGR (Compounded Annual Growth Rate), XIRR (Extended Internal Rate of Return), and absolute return are all measures of different aspects of performance.

For instance, absolute return merely measures the total return from the start of the investment period to the end. If Rs 1 lakh has grown to Rs 1.75 lakh over five years, the absolute return would be 75 per cent. But this percentage does not tell us how quickly the money is compounded.

If calculated on the basis of CAGR, which assumes annual compounding, the rate of return in this case would be approximately 11.8 per cent per annum. This measure is most appropriate for lump sum investments, wherein the amount is invested all at once and then held for a fixed period of time.

Therefore, a clear understanding of mutual fund returns is essential for making informed investment decisions. The three primary metrics used to evaluate mutual fund performance are Absolute Return, CAGR (Compounded Annual Growth Rate), and Extended Internal Rate of Return (XIRR).

Decoding mutual fund return metrics

Understanding mutual fund performance requires looking beyond a single return figure. Different metrics measure different aspects of growth, depending on investment duration and style. Here’s a simplified breakdown in sentences and bullet points:

Absolute return measures the total gain or loss from the beginning to the end of an investment period.

CAGR (Compounded Annual Growth Rate)

CAGR represents the annualised average growth rate of an investment, assuming profits are reinvested and growth is compounded.

XIRR (Extended Internal Rate of Return)

XIRR calculates the actual return by considering the timing and amount of each investment cash flow.

What should investors do?

Investors often concentrate on the headline return figures without knowing how these figures are arrived at. But mutual fund return analysis cannot be done in a vacuum.

As explained by experts, the right way to do it is metric-dependent and case-dependent:

Use CAGR when comparing returns of similar funds over similar long-term periods.

Use XIRR when comparing SIPs or staggered investments to understand the actual return experience.

Use absolute return only as a quick sneak peek, especially for short-term periods.

The key to smart investing is to understand what the return figure actually stands for, rather than being lured by the highest percentage figure.

Experts also warn investors not to be misled by the attractive absolute return figures. When it comes to lump sum investments over several years, CAGR provides a better insight into annual returns, while XIRR provides a better insight into SIP returns.

(Disclaimer: The above article is meant for informational purposes only, and should not be considered as any investment advice. ET NOW DIGITAL suggests its readers/audience to consult their financial advisors before making any money related decisions.)